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Chapter 09 - Prospective Analysis

Prospective Analysis
REVIEW
Prospective analysis is the final step in the financial statement analysis process. It
includes forecasting of the balance sheet, income statement and statement of cash
flows. Prospective analysis is central to security valuation. Both the free cash flow
and residual income valuation models described in Chapter 1 require estimates of
future financial statements. We provide a detailed example of the forecasting
process to project the income statement, the balance sheet, and the statement of
cash flows. We describe the relevance of forecasting for security valuation and
provide an example utilizing forecasted financial statements to implement the
residual income valuation model. We discuss the concept of value drivers and their
reversion to long-run equilibrium levels. In the appendix, we provide a detailed
example of short-term cash flow forecasting.

9-1

Chapter 09 - Prospective Analysis

OUTLINE

The Projection Process


Projecting Financial Statements
Application of Prospective Analysis in the Residual Income Valuation Model
Trends in Value Drivers

Short-term Forecasting (Appendix)

9-2

Chapter 09 - Prospective Analysis

ANALYSIS OBJECTIVES

Describe the importance of prospective analysis.

Explain the process of projecting the income statement, the balance sheet and the
statement of cash flows.

Discuss and illustrate the Importance of Sensitivity Analysis.

Describe the implementation of the projection process in the valuation of equity


securities.

Discuss the concept of value drivers and their reversion to long-run equilibrium
levels.

9-3

Chapter 09 - Prospective Analysis

QUESTIONS
1. Prospective analysis is central to security valuation. All valuation models rely on
forecasts of earnings or cash flows that are, then, discounted back to the present to
arrive at the estimated value of the security. Prospective analysis is also useful to
examine the viability of companies strategic plans, that is, whether they will be able to
generate sufficient cash flows from operations to finance expected growth or whether
they will be required to seek external financing. In addition, prospective analysis is
useful to examine whether announcing strategies will yield the benefits expected by
management. Finally, prospective analysis can be used by creditors to assess
companies ability to meet debt service requirements.
2. Prior to the forecasting process, financial statements can be recast to better portray
economic reality. Adjustments might include elimination of transitory items or
reallocating them to past or future years, capitalizing (expensing) items that have been
expensed (capitalized) by management, capitalizing operating leases and other forms of
off-balance sheet financing, and so forth.
3. In addition to trend analysis, analysts frequently incorporate external (non-financial)
information into the prospective process. Some examples are the expected level of
macroeconomic activity, the degree to which the competitive landscape is changing, any
strategic initiatives that have been announced by management, and so forth.
4. The forecast horizon is the period for which specific estimates are made. It is usually 5-7
years. Forecasts beyond the forecast horizon are of dubious value since estimates are
uncertain.
5. Since all valuation models are infinite horizon models, analysts frequently assume a
steady state into perpetuity after the forecast horizon. A common assumption is that the
company will grow at the long-run rate of inflation, that is, remaining constant in real
terms.
6. The projection process begins with an expected growth in sales. Gross profit and
operating expenses are, then, estimated as a percentage of forecasted sales using
historical ratios and external information. Depreciation expense is usually estimated as a
percentage of beginning gross depreciable assets under the assumption that
depreciation policies will remain constant. Interest expense is usually estimated at an
average borrowing rate applied to the beginning balance of interest bearing liabilities.
Projections of expected interest rates are used for variable rate indebtedness and new
borrowings. Finally, tax expense is estimated using the effective tax rate on pre-tax
income.
7. In the first step, balance sheet items are projected using forecasted income sales
(COGS) and relevant turnover ratios. Long-term assets are projected using forecasted
capital expenditures. Long-term liabilities are projected from current maturities of longterm debt disclosed in the debt footnote, and paid-in-capital is assumed to be constant in
this stage. Retained earnings are projected adding (subtracting) projected profits
(losses) and subtracting projected dividends. Once total liabilities and equities are
forecasted, total assets is set equal to this amount and forecasted cash is computed as
the plug figure.

9-4

Chapter 09 - Prospective Analysis

In the second step, long-term liabilities and equities are adjusted to yield the desired
level of cash. The analyst must be careful to maintain the historical leverage ratio and
adjust liabilities and equities proportionately.
8. The residual income model expresses stock price as the book value of stockholders
equity plus the present value of expected residual income (RI). Residual income can be
expressed in ratio form as,
RI = (ROEt k) * BVt-1
Where ROE=NIt/BVt-1. This form highlights the fact that stock price is only impacted so
long as ROE k. In equilibrium, competitive forces will tend to drive rates of return (ROE)
to cost (k) so that abnormal profits are competed away. The estimation of stock price,
then, amounts to the projection of the reversion of ROE to its long-run value for a
particular company and industry. ROE is a value driver since it impacts our valuation of
the stock price. Its components (asset turnover and profit margin) are also value drivers
9. We can make two observations regarding the reversion of ROE:
a. ROEs tend to revert to a long-run equilibrium. This reflects the forces of competition.
Furthermore, the reversion rate for the least profitable firms is greater than that for
the most profitable firms. And finally, reversion rates for the most extreme levels of
ROE are greater than those for firms at more moderate levels of ROE.
b. The reversion is incomplete. That is, there remains a difference of about 12% between
the highest and lowest ROE firms even after ten years. This may be the result of two
factors: differences in risk that are reflected in differences in their costs of capital (k);
or, greater (lesser) degrees of conservatism in accounting policies.
The reversion of ROA and NPM are similar. While some reversion of TAT is evident, it is
much less than that of the other value drivers.
10. Short-term cash forecasts are key to assessments of short-term liquidity. An asset is
called "liquid" because it will or can be converted into cash within the current period.
The analysis of short-term cash forecasts will reveal whether an entity will be able to
repay short-term loans as planned. This also means such analysis is extremely
important for a potential short-term credit grantor. Short-term cash forecasts often are
relatively realistic and accurate because of the shortness of the time span covered.
11. A cash forecast, to be most meaningful, must be for a relatively short-term period of
time. There are many unpredictable variables involved in the preparation of a reliable
forecast for a highly liquid asset such as cash. Over a long period of time (that is,
beyond the time span of one year), the difference in the degree of liquidity among items
in the current assets group is usually insignificant. What is more important for long time
spans are the projections of net income and other sources and uses of funds. The focus
should be shifted to working capital (and other accrual measures), and away from cash
flows, for longer forecast horizons of, say, thirty monthswhere the time required to
convert current assets into cash is insignificant.

9-5

Chapter 09 - Prospective Analysis

12. Cash inflows and outflows are highly interrelated. These two flows are crucial to a
companys circulation system." A deficiency in any part of the system can affect the
entire system. For example, a reduction or cessation of sales affects the vital conversion
of finished goods into receivables or cash, which in turn leads to a drop in the cash
reservoir. If the system is not strengthened by "transfusion" (such as additional
investment by owners or creditors), production must be curtailed or discontinued. Lack
of cash inflows also will reduce other expenses such as advertising, promotion, and
marketing expenses, which will further adversely affect sales. This can yield a vicious
cycle leading to business failure.
13. Most would agree with this assertion. Cash is the most liquid asset and when
management urgently needs to purchase assets or incur expenses, a cash exchange is
the quickest and easiest means to execute a transaction. Moreover, unless management
has a credit line established with a reliable outsider (such as a revolving account at a
bank), lack of cash can mean a permanent loss of profitable opportunities.
14. Ratio analysis is a static measurement tool. Ratios measure relations among financial
statement items as of a given moment and time. In contrast, funds flow analysis is a
dynamic measure covering a period of time. A dynamic model of funds flow analysis
uses the present only as a starting point and utilizes the best available estimates of
future plans and conditions to forecast the future availability and disposition of cash or
working capital. Analyzing funds flow also encompasses the projected operations of a
company. Since one of the fundamental assumptions of accounting is the going-concern
concept, some assert that the dynamic model is more realistic and is superior to static
representations. However, care should be taken in placing too much reliance on funds
flow analysis as it is primarily based on estimates, and not on realized observations.
15. Except for transactions involving the raising of money from external sources (such as
through loans or additional investments) and the investments of money in long-term
assets, almost all internally generated cash flows relate to and depend on sales.
Accordingly, the usual first step in preparing a cash forecast is to estimate sales for the
period under consideration. The reliability of any cash forecast depends on the accuracy
of this forecast of sales. In arriving at the sales forecast, the analyst should consider: (1)
past trends of sales volume, (2) market share, (3) industry and general economic
conditions, (4) productive and financial capacity, and (5) competitive factors, among
other variables.

9-6

Chapter 09 - Prospective Analysis

EXERCISES
Exercise 9-1 (45 minutes)
Projected Income Statement for Year 12
Quaker Oats Company
Forecasted Income Statement
For Year Ended June 30, Year 12
Revenues [given] .................................................................

$6,000.0

Costs and expenses


Cost of goods sold [a] ...................................................

$3,186.0

Selling, general, and administrative [b] .......................

2,439.4

Other expenses [c] .........................................................

35.2

Interest, net [d] ...............................................................

91.4

Total costs and expenses ...................................................

5,752.0

Income from continuing operations .................................

248.0

Income taxes [e] ...................................................................

105.9

Income before discontinued operations ..........................

142.1

(Loss) on disposal of discontinued operations [given] ...


Net income ...........................................................................

(2.0)
$ 140.1

Notes:
[a] Cost of sales is estimated to be at a level representing the average percentage of cost of
sales to sales as prevailed in the four-year period ending June 30, Year 11, which is 53.1%
(19,909.2 9,331.3)/19,909.2. Therefore, 6,000 x .531 = $3,186.
[b] Selling, general & administrative expenses in Year 12 are expected to increase by the
same percentage as these expenses increased from Year 10 to Year 11, which is 15%.
Therefore, $2,121.2 x 1.15 = $2,439.4.
[c] Other expenses are expected to be 8% higher in Year 12. Therefore, 32.6 x 1.08 = $35.2.
[d] Interest expense (net of interest capitalized) and interest income will increase by 6% due
to increased financial needs. Therefore, $86.2 x 1.06 = $91.4
[e] The effective tax rate in Year 12 will equal that of Year 11, which is 42.7% ($175.7/$411.5).
Therefore, tax expense = $248 x .427 = $105.9.

9-7

Chapter 09 - Prospective Analysis

Exercise 9-2 (25 minutes)


Spreadsheet to Compute Forecasts of Sales and Income
Date
Dec-Y1
Mar-Y2
Jun-Y2
Sep-Y2
Dec-Y2
Mar-Y3
Jun-Y3
Sep-Y3
Dec-Y3
Mar-Y4
Jun-Y4
Sep-Y4
Dec-Y4
Mar-Y5
Jun-Y5
Sep-Y5
Dec-Y5
Mar-Y6
Jun-Y6
Sep-Y6
Dec-Y6
Mar-Y7
Jun-Y7
Sep-Y7
Dec-Y7
Mar-Y8
Jun-Y8
Sep-Y8
Dec-Y8
Mar-Y9
Jun-Y9
Average
change
for each
quarter

Forecast
Sep.Y9*
Forecast
Dec.Y9*
Forecast
Mar. Y0*
Forecast
Jun. Y0*

Sales

$17,349
12,278
13,984
13,972
16,040
12,700
14,566
14,669
17,892
12,621
14,725
14,442
17,528
14,948
17,630
17,151
19,547
16,931
18,901
19,861
22,848
19,998
21,860
21,806
24,876
22,459
24,928
23,978
28,455
24,062
27,410

N.I.

$1,263
964
1,130
996
1,215
1,085
656
1,206
1,477
1,219
1,554
1,457
1,685
1,372
1,726
1,610
1,865
1,517
1,908
1,788
2,067
1,677
2,162
2,014
2,350
1,891
2,450
2,284
2,671
2,155
2,820

Change
In Dec.
Sales

-$1,309

Change
in Dec.
NI

Change
In March
Sales

in March

Change

$422

$121

NI

Change
In June
Sales

2,709

153

2,710

178

1,945

226

2,172

270

$1,667.67

$214.67

25,645.67

2,498.67

172

182

202
3,067

160
2,959

254

283
2,461

214
3,068

288

321
1,603

30,041.57

251

145
1,271

$1,586.57

-227

898

180
1,983

3,579

$210

153
2,905

2,028

$697

208
2,327

3,301

-$474

134
159

2,019

Change
in Sept.
NI

262
-79

-364

Change
In Sept.
Sales

-$48
$582

1,852

Change
In June
NI

$201.14 $1,683.43

264

$170.14

2,482

370

$1,918.00

$241.43

2,872.14
25,745.43

2,325.14
29,328.00

* Most recent actual quarter + average change for the quarter.


Note: Reported quarterly sales and net income for General Electric are:
Net income
Sales
Sep Y9
$27,200
$2,653
Dec Y9
32,855
3,089
Mar Y0
29,996
2,592

9-8

3,061.43

Chapter 09 - Prospective Analysis

Exercise 9-3 (40 minutes)


a. To illustrate how predictions of market share and total market sales can be used
in the forecasting process, consider the following example. If an analyst, for
instance, predicts that (i) Cough.com will maintain its 0.08% share of the market
for children's cough medicine and (ii) total Industry sales of children's cough
medicine for year 2006 is $3.2 billion, then a reasonable estimate of Cough.com's
year 2006 sales is $2.56 million. This is computed as 0.08% market share
multiplied by the expected $3.2 billion of industry sales.
b. All relevant data should be sought out, subject to cost-benefit considerations, in
the prediction of sales. The importance of sales to predictions of financial
performance and financial condition cannot be overemphasized. Accordingly,
companies invest considerable research and effort in predicting sales. Regarding
what types of data to seek and how to obtain them, lets consider a retailer. To
project the sales of a retailer, an analyst might consider visiting outlets that sell
the retailers products and observe customer-buying patterns versus the patterns
observed for key competing products. This activity can be done using anecdotal
observation or using formal statistical sampling depending upon the analysts'
perceived need for accuracy. Moreover, the analyst can seek information from
insiders via interview or interpretation of formal or informal disclosures made by
the company. The analyst can also review company strategies and industry
trends. In sum, good predictions involve more than sophisticated modelsthey
demand that the analyst take the perspective of a customer constrained by the
economic environment predicted to exist.
c. Relying on predicted year 2006 total industry sales of $3.2 billion, the sales of
Cough.com are predicted to be as follows
2006 Market share is 5% greater
[105% x .08%] x $3.2 billion
= $2.688 million

2006 Market share is 5% worse


[95% x .08%] x $3.2 billion
= $2.432 million

d. What-If industry sales are 10% higher:


[105% x .08%] x [110% x $3.2 billion]
= $2.9568 million
What-If industry sales are 10% lower:
[105% x .08%] x [90% x $3.2 billion]
= $2.4192 million

9-9

[95% x .08%] x [110% x $3.2 billion]


= $2.6752 million
[95% x .08%] x [90% x $3.2 billion]
= $2.1888 million

Chapter 09 - Prospective Analysis

Exercise 94A (30 minutes)


Lyon Corporation
Cash Forecast
For July, Year 6
Beginning cash balance ......................................................

$ 20

Cash collections
Beginning accounts receivable ...............................

$ 20

Sales for month .........................................................

150
170

Less: Ending accounts receivable ..........................

21

Cash available ......................................................................

149
$169

Cash disbursements
Beginning accounts payable ...................................

18

Purchases (note a) ....................................................

115
133

Ending accounts payable (25% of purchases) .......

29

104

Miscellaneous outlays ..............................................

11

Cash balance .............................................................

$ 54

Minimum cash balance desired ...............................

30

Excess cash ..............................................................

$ 24

[a] Ending inventory .......................................................................................................


Cost of goods sold (5/6 of sales) .............................................................................
Less beginning inventory .........................................................................................
Purchases ..................................................................................................................

9-10

$ 15
125
140
25
$115

Chapter 09 - Prospective Analysis

PROBLEMS
Problem 9-1 (90 minutes)
a.
Coca-Cola
Year 3
Estimate
20,297

Year 2
20,092

Year 1
19,889

6,106

6,044

6,204

14,191

14,048

13,685

7,972

7,893

9,221

Depreciation & amortization expense

863

803

773

Interest expense

-66

-308

292

Income before tax

5,422

5,660

3,399

Income tax expense

1,620

1,691

1,222

Net income

3,802

3,969

2,177

Outstanding shares

3,491

3,491

3,481

1.02%

1.02%

Gross Profit Margin

69.92%

69.92%

Selling General & Administrative Exp / Sales

39.28%

39.28%

Depreciation (depn exp / pr yr PPE gross)

12.14%

12.14%

INT (int / pr yr LTD)

-5.45%

-5.45%

Tax (Inc Tax / Pre-tax inc)

29.88%

29.88%

INCOME STATEMENT
Net sales
Cost of goods
Gross profit
Selling general & administrative expense

RATIOS
Sales growth

9-11

Chapter 09 - Prospective Analysis

Problem 9-1 continued


Year 3
Estimate
587
1,901
1,066
2,300
5,854

Year 2
1,934
1,882
1,055
2,300
7,171

Year 1
1,892
1,757
1,066
1,905
6,620

8,305
3,515
4,791
10,793
21,438

7,105
2,652
4,453
10,793
22,417

6,614
2,446
4,168
10,046
20,834

3,717
3,899
815
8,431

3,679
3,899
851
8,429

3,905
4,816
600
9,321

Deferred income, taxes & other


Long term debt
Total liabilities

1,403
1,219
11,053

1,403
1,219
2,622

1,362
835
2,197

Common stock
Capital surplus
Retained earnings
Treasury stock
Shareholder equity
Total liabilities & net worth

873
3,520
19,674
13,682
10,385
21,438

873
3,520
20,655
13,682
11,366
22,417

870
3,196
18,543
13,293
9,316
20,834

RATIOS
AR turn
INV turn
AP turn
Tax Pay (Tax pay / tax exp)
FLEV
Div/sh

10.68
5.73
1.64
50.33%
2.06
$1.37

10.68
5.73
1.64
50.33%
1.97
$1.37

11.32
5.82
1.59
49.10%
2.24
$1.21

1,200
5.91%

1188
5.91%

1165
5.86%

BALANCE SHEET
Cash
Receivables
Inventories
Other
Total current assets
Property, plant & equipment
Accumulated depreciation
Net property & equipment
Other assets
Total assets
Accounts payable & accrued liabilities
Short-term debt & cmltd
Income taxes
Total current liab

CAPEX
CAPEX/Sales

9-12

Chapter 09 - Prospective Analysis

Problem 9-1 continued


Year 3
Estimate

Statement of Cash Flows


Net income

3,802

Depreciation

863

Accounts receivable

-19

Inventories

-11

Accounts payable

38

Income taxes

-36

Net cash flow from operations

4,636

CAPEX
Net cash flow from investing activities

-1,200
-1,200

Long term debt


Additional paid in capital
Dividends
Net cash flow from financing activities

0
0
-4,783
-4,783
_____
-1,347
1,934
587

Net change in cash


Beginning cash
Ending cash

b. Based on our initial projection of Coca-Colas balance sheet, it appears that the
company will require approximately $1.5 billion of external financing in Year 3.
This amount will yield a cash balance of approximately $2 billion, consistent with
prior years.

9-13

Chapter 09 - Prospective Analysis

Problem 9-2 (95 minutes)


a.
Best Buy
Year 3
Estimate

Year 2

Year 1

Net sales

18,800

15,326

12,494

Cost of goods

15,048

12,267

10,101

Gross profit

3,752

3,059

2,393

Selling general & administrative expense

2,761

2,251

1,728

Depreciation & amortization expense

304

167

103

Income before tax

688

641

562

Income tax expense

263

245

215

Net income

425

396

347

Outstanding shares

208

208

200

Sales growth

22.67%

22.67%

Gross Profit Margin

19.96%

19.96%

Selling General & Administrative Exp / Sales

14.69%

14.69%

DEPRECIATION (depn exp / pr yr PPE gross)

15.28%

15.28%

Tax (Inc Tax / Pre-tax inc)

38.22%

38.22%

Income statement

RATIOS

9-14

Chapter 09 - Prospective Analysis

Problem 9-2 continued


Year 3
Estimate
196
384
2,168
102
2,850

Year 2
746
313
1,767
102
2,928

Year 1
751
262
1,184
41
2,238

Property, plant & equipment


Accumulated depreciation
Net property & equipment
Other assets
Total assets

3,249
847
2,403
466
5,719

1,987
543
1,444
466
4,838

1,093
395
698
59
2,995

Accounts payable & accrued liabilities


Short-term debt & cmltd
Income taxes
Total current liab

3,034
114
136
3,284

2,473
114
127
2,714

1,704
16
65
1,785

122
67
189

122
181
303

100
15
115

Common stock
Capital surplus
Retained earnings
Shareholder equity
Total liabilities & net worth

20
576
1,650
2,246
5,719

20
576
1,225
1,821
4,838

20
247
828
1,095
2,995

RATIOS
AR turn
INV turn
AP turn
Tax Pay (Tax pay / tax exp)
FLEV
Div/sh

48.96
6.94
4.96
51.84%
2.55
$0.00

48.96
6.94
4.96
51.84%
2.66
$0.00

47.69
8.53
5.93
30.23%
2.74
$0.00

1,262
6.71%

1029
6.71%

416
3.33%

BALANCE SHEET
Cash
Receivables
Inventories
Other
Total current assets

Long term liabilities


Long term debt
Total long-term liabilities

CAPEX
CAPEX/Sales

9-15

Chapter 09 - Prospective Analysis

Problem 9-2 continued


Year 3
Estimate
425
304
-71
-401
561
9
827

Statement of Cash Flows


Net income
Depreciation
Accounts receivable
Inventories
Accounts payable
Income taxes
Net cash flow from operations
CAPEX
Net cash flow from investing activities

-1,262
-1,262

Long term debt


Additional paid in capital
Dividends
Net cash flow from financing activities

-114
0
0
-114
____
-550
746
196

Net change in cash


Beginning cash
Ending cash

b. Based on our projection, it appears that Best Buy will require about $550 Million
of external financing to yield a cash balance of approximately $750 million.
Analysts must allocate this external financing between debt and equity so as to
preserve the financial leverage level presently used by Best Buy.

9-16

Chapter 09 - Prospective Analysis

Problem 9-3 (90 minutes)


a.
Merck
Year 3
Estimate

Year 2

Year 1

Net sales

56,435

47,716

40,343

Cost of goods

34,272

28,977

22,444

Gross profit

22,164

18,739

17,900

Selling general & administrative expense

7,725

6,531

6,469

Depreciation & amortization expense

1,661

1,464

1,277

237

342

329

12,541

10,403

9,824

Income tax expense

3,762

3,121

3,002

Net income

8,779

7,282

6,822

Outstanding shares

2,976

2,976

2,968

Sales growth

18.27%

18.27%

Gross Profit Margin

39.27%

39.27%

Selling General & Administrative Exp / Sales

13.69%

13.69%

DEPRECIATION (depn exp / pr yr PPE gross)

8.76%

8.76%

INT (int / pr yr LTD)

4.94%

4.94%

30.00%

30.00%

INCOME STATEMENT

Interest expense
Income before tax

RATIOS

Tax (Inc Tax / Pre-tax inc)

9-17

Chapter 09 - Prospective Analysis

Problem 9-3 continued


Year 3
Estimate
5,254
6,168
4,233
880
16,536

Year 2
3,287
5,215
3,579
880
12,961

Year 1
4,255
5,262
3,022
1,059
13,598

Property, plant & equipment


Accumulated depreciation
Net property & equipment
Other assets
Total assets

24,056
7,514
16,543
17,942
51,020

18,956
5,853
13,103
17,942
44,007

16,707
5,225
11,482
15,075
40,155

Accounts payable & accrued liabilities


Short-term debt & cmltd
Income taxes
Total current liab

6,983
4,067
1,897
12,947

5,904
4,067
1,573
11,544

5,391
3,319
1,244
9,954

Deferred income, taxes and other


Long term debt
Total liabilities

11,614
4,787
29,347

11,614
4,799
27,957

11,768
3,601
25,323

Common stock
Capital surplus
Retained earnings
Treasury stock
Shareholder equity
Total liabilities & net worth

30
6,907
37,123
22,387
21,673
51,020

30
6,907
31,500
22,387
16,050
44,007

30
6,266
27,395
18,858
14,832
40,155

RATIOS
AR turn
INV turn
AP turn
Tax Pay (Tax pay / tax exp)
FLEV
Div/sh
CAPEX
CAPEX/Sales

9.15
8.10
4.91
50.41%
2.35
$1.06
5,100
9.04%

9.15
8.10
4.91
50.41%
2.74
$1.06
4312
9.04%

7.67
7.43
4.16
41.45%
2.71
$0.98
3641
9.03%

BALANCE SHEET
Cash
Receivables
Inventories
Other
Total current assets

9-18

Chapter 09 - Prospective Analysis

Problem 9-3 continued


Year 3
Estimate

Statement of Cash Flows


Net income

$ 8,779

Depreciation

1,661

Accounts receivable

-953

Inventories

-654

Accounts payable

1,079

Income taxes

323

Net cash flow from operations

10,235

CAPEX

-5,100

Net cash flow from investing activities

-5,100

Long term debt

-12

Additional paid in capital

Dividends

-3,156

Net cash flow from financing activities

-3,168
_____

Net change in cash

1,967

Beginning cash

3,287

Ending cash

5,254

b. Based on our initial projections, it appears that Merck will have excess cash of
approximately $2 billion in year 3. This excess cash should be used to reduce
both debt and equity so as to maintain historical financial leverage.

9-19

Chapter 09 - Prospective Analysis

Problem 9-4 (90 minutes)


Historical
figures
Year 2 Year 3
Sales growth
Net profit Margin (Net income/Sales)
NWC turn (Sales/avg NWC)
FA turn (Sales/avg FA)
Total operating assets/Total equity
Cost of equity
($ Thousands)
Sales
Net income ($ Mil)
Net working capital
Fixed assets
Total Operating assets
L-T Liabilities
Total Stockholder's Equity ($ Mil)
Residual Income Computation
Net Income
Beginning Equity
Required Equity Return
Expected Earnings
Residual Income
Discount factor
Present value of residual income
Cum PV residual income
Terminal value of abnormal earnings
Beg book value of equity
Value of equity - Abnormal Earnings
Common shares outstanding (mil)
per share

Forecast
Horizon
Year 4 Year 5

Year 6

Year 7

20x8

Terminal
Year
20x8
3.50%
8.22%
9.33
1.64
2.01

8.50%
6.71%
8.98
1.67
1.96

10.65%
8.22%
9.33
1.64
2.01

10.65%
8.22%
9.33
1.64
2.01
12.5%

10.65%
8.22%
9.33
1.64
2.01

10.65%
8.22%
9.33
1.64
2.01

10.65%
8.22%
9.33
1.64
2.01

10.65%
8.22%
9.33
1.64
2.01

25,423
1,706
2,832
15,232
18,064
8,832
9,232

28,131
2,312
3,015
17,136
20,151
10,132
10,019

31,127
2,558
3,336
18,961
22,297
11,211
11,086

34,443
2,831
3,692
20,981
24,673
12,405
12,267

38,112
3,132
4,085
23,216
27,301
13,727
13,574

42,171
3,466
4,520
25,689
30,209
15,189
15,020

46,663
3,835
5,001
28,425
33,426
16,807
16,619

48,297
3,969
5,176
29,420
34,596
17,395
17,201

2,558
10,019
12.5%
1,252
1,306
0.89

2,831
11,086
12.5%
1,386
1,445
0.79

3,132
12,267
12.5%
1,533
1,599
0.70

3,466
13,574
12.5%
1,697
1,769
0.62

3,835
15,020
12.5%
1,877
1,958
0.55

3,969
16,619
12.5%
2,077
1,892

1,161
1,161

1,142
2,303

1,123
3,425

1,105
4,530

1,086
5,616
11,665
10,019
27,301
1,737
$15.72

9-20

Chapter 09 - Prospective Analysis

Problem 9-5 (90 minutes)


a.
Telnet Corporation
Pro Forma Income Statement ($000s)
Six Months Ended June 30, Year 2
Sales revenue ($250 x 6 mos.) ....................................................................

$1,500

Cost of goods sold (note [a]) ......................................................................

1,199

Gross margin ...............................................................................................

301

Selling and administrative expenses ($47.5 x 6 mos.) .............................

285

Expected pre-tax income ............................................................................

16

Estimated income taxes (at 50%) ...............................................................

Expected net income ...................................................................................

Note [a]: We use T-accounts to compute cost of goods sold ($ thousands)


Raw Material Inventory
Beginning (given)
Material purchases ($125 x 6 mos.)
Ending (given)

0
750

715

To W.I.P. inventory [a] (plug)

35
Work in Process Inventory

Beginning (given)
From raw materials inventory [a]
Labor ($30.5 x 6 mos.)
Variable overhead ($22.5 x 6 mos.)
Rent ($10 x 6 mos.)
Depreciation ($35 x 6 mos.)
Patent amortization ($.5 x 6 mos.)
Ending (given)

0
715
183
135
60
210
3

7
1,299

Prepaid expenses (given)


To F.G. inventory [b] (plug)

0
Finished Goods Inventory

Beginning (given)
From W.I.P. inventory [b]
Ending (given)

0
1,299

1,199

100

9-21

Cost of goods sold (plug)

Chapter 09 - Prospective Analysis

Problem 9-5 continued


b.
Telnet Corporation
Pro forma Balance Sheet ($000s)
June 30, Year 2
ASSETS
Cash ............................................................................. $

40

(minimum cash)

Accounts receivable ...................................................

375

(45 days' sales)*

Inventories ($35 + $100) .............................................

135

(given)

Prepaid expenses........................................................

(given)

Total current assets ..................................................

557

(subtotal)

Equipment ...................................................................

1,200

(given)

Less accumulated depreciation.................................

210

($35 x 6 mos.)

Equipment, net ..........................................................

990

(subtotal)

Patents .........................................................................

40

(given)

Less amortization........................................................

($500 x 6 mos.)

Patents, net ................................................................

37

(subtotal)

Total Assets ................................................................. $1,584


LIABILITIES AND STOCKHOLDERS EQUITY
Accounts payable ....................................................... $ 125

(30 days' purchases)**

Accrued taxes..............................................................

(from Inc. Stmt.)

Stockholders' equity ...................................................

1,300

(given)

Retained earnings .......................................................

(from Inc. Stmt.)

Additional funds needed ............................................

143

"plug"

Total liabilities and equity .......................................... $1,584


* ($250,000 x 6) / 180 days = $8,333 per day x 45 days = $375,000
** ($125,000 x 6) / 180 days = $4,166 per day x 30 days = $125,000

9-22

Chapter 09 - Prospective Analysis

Problem 9-5 continued


c.
Telnet Corporation
Forecasted Statement of Cash Flows
For Six Months Ended June 30, Year 2
Cash balance, beginning ...................................................

60,000

Add collection of accounts receivable * ...........................

1,125,000

$1,185,000

Less disbursements for


Material purchases ** ....................................................

625,000

Labor ..............................................................................

183,000

Rent ................................................................................

60,000

Overhead ........................................................................

135,000

Selling expense .............................................................

285,000

Tentative cash balance .......................................................

(1,288,000)
$ (103,000)

Minimum cash balance required .......................................

40,000

Additional borrowing required...........................................

$ 143,000

Ending cash balance .........................................................

Loan balance .......................................................................

$ 143,000

40,000

* Collection of accounts receivable


Sales ..........................................................................
Collections ................................................................
Accumulated Collections ........................................

Jan.
250
0
0

Feb.
250
125
125

Mar.
250
250
375

Apr.
250
250
625

May
250
250
875

June
250
250
1,125

** Payment of accounts payable


Purchases .................................................................
Payments ..................................................................
Accumulated Payments ..........................................

Jan.
125
0
0

Feb.
125
125
125

Mar.
125
125
250

Apr.
125
125
375

May
125
125
500

June
125
125
625

9-23

Chapter 09 - Prospective Analysis

Problem 9-6 (95 minutes)


Quaker Oats
Forecasted Statement of Cash Flows
For Year Ended June 30, Year 12
Cash provided by (used for) operations
Net income (a) .............................................................................................
Items in income not affecting cash
Depreciation & amortization (b) ...............................................................
Deferred income taxes (c) ........................................................................
Provision for restructuring charges (given) ...........................................
Increase in receivables (d) .........................................................................
Increase in inventories (e) ..........................................................................
Increase in other current assets (f) ...........................................................
Increase in accounts payable (g)...............................................................
Increase in other current liabilities (h) ......................................................
Cash provided by operating activities ......................................................

$ 238.8
196.6
54.7
0.0
(8.9)
(45.2)
(25.6)
42.1
24.5
$ 477.0

Cash provided by (used for) investment activities


Capital expenditures, PP&E (given) ..........................................................
Asset retirements (given) ...........................................................................
Other changes (given) ................................................................................
Cash used for investing activities .............................................................

$ (300.0)
20.0
(30.0)
$ (310.0)

Cash provided by (used for) financing activities


Repayments of L-T debt (given) ................................................................
Net decrease in S-T debt (given) ...............................................................
Cash dividend paid (given) ........................................................................
Additions to L-T debtplug (i) ..................................................................
Cash provided by financing activities .......................................................

$ (45.0)
(40.0)
(135.0)
55.8
$(164.2)

Net increase in cash (j) ...............................................................................

Cash, beginning balance ............................................................................


Cash, balance at end of year......................................................................

30.2
$ 33.0

Notes:
(a) Average percent of income from continuing operations to sales, Years 9-11
($235.8 +$228.9 + $148.9) / ($5,491.2 + $5,030.6 + $4,879.4) = 3.98%
Net income in Year 12 = $6,000 x .0398 = $238.8

9-24

2.8

Chapter 09 - Prospective Analysis

Problem 9-6 continued


(b) Depreciation and amortization in Year 12 = $238.8 x .8233 = $196.6
(c) Average percent of deferred income taxes (noncurrent) and other items to income from
continuing operations, Years 9-11: $140.4 / $613.6 = 22.9%
Noncurrent deferred income tax in Year 12 = $238.8 x .229 = $54.7
(d) Ending accounts receivable = $6,000 x (42/360) = $700.0
For Year 12: Accounts receivable, beg
$691.1
Accounts receivable, end
700.0
Increase
$ 8.9
(e) Year 12 cost of sales = $6,000 x .51 = $3,060
Ending inventory = $3,060 x (55/360) = $467.5
For Year 12: Inventory, beg $422.3
Inventory, end
467.5
Increase
$ 45.2
(f) ($13.7 + $14.1 + $48.9)/3 = $25.6
(g) Year 12 purchases = $2,807.2 x 1.12 = $3,144.1
Accounts payable, end = $3,144.1 x (45/360) = $393.0
For Year 12: Accounts payable, beg
$350.9
Accounts payable, end
393.0
Increase
$ 42.1
(h) ($43.2 + $83.4 - $53.1)/3 = $24.5
(i) Amount required to balance statement.
(j) Percent of cash to revenues in Year 11 = $30.2 / $5,491.2 = 0.55%
Year-end cash in Year 12 = $6,000 x 0.55% = $33
Increase in cash for Year 12 = $33 - $30.2 = $2.8

9-25

Chapter 09 - Prospective Analysis

CASES
Case 9-1 (60 minutes)
Kodak
INCOME STATEMENT

20x7 Est

20x6

20x5

12,515

13,234

13,994

Cost of goods

8,199

8,670

8,375

Gross profit

4,316

4,564

5,619

Selling general & administrative expense


(except depreciation)

1,761

1,862

1,776

Depreciation expense

766

765

738

Research & development costs

737

779

784

Goodwill amortization

154

151

Restructuring costs (credits)

659

-44

1,052

345

2,214

208

219

178

18

18

-96

Income before tax

827

108

2,132

Income tax expense

245

32

725

Net income

582

76

1,407

Outstanding shares

290

290

290

-5.43%
34.49%
14.07%
5.90%
5.89%
6.49%
29.63%

-5.43%
34.49%
14.07%
5.90%
5.89%
6.49%
29.63%

Net sales

Earnings from operations


Interest expense
Other expense (income)

RATIOS
Sales growth
Gross Profit Margin
Selling General & Administrative Exp / Sales
DEPRECIATION (depn exp / pr yr PPE gross)
R&D/sales
INT (int / pr yr STD and LTD)
Tax (Inc Tax / Pre-tax inc)

9-26

Chapter 09 - Prospective Analysis

Case 9-1 continued


BALANCE SHEET
Cash
Receivables
Inventories
Other
Total current assets

20x7 Est
$ 17
2,210
1,075
761
4,064

Property, plant & equipment


Accumulated depreciation
Net property & equipment
Other assets
Total assets

20x6
$ 448
2,337
1,137
761
4,683

20x5
$ 246
2,653
1,718
874
5,491

13,972 12,982 12,963 (NOTE 4)


8,089
7,323
7,044
5,883
5,659
5,919
3,020
3,020
2,802
$12,967 $13,362 $14,212

Accounts payable & accrued liabilities


Short-term debt
Current maturities of l-t debt
Income taxes
Total current liab

3,098
1,378
13
544
5,033

3,276
1,378
156
544
5,354

Long term debt


Postemployment liabilities
Other long-term liabilities
Total liabilities

1,653
2,728
720
10,134

1,666
2,728
720
10,468

1,166
2,722
681
10,784

Common stock
Capital surplus
Retained earnings
Treasury stock
Shareholder equity
Total liabilities & net worth

978
849
6,773
5,767
2,833
12,967

978
849
6,834
5,767
2,894
13,362

978
871
7,387
5,808
3,428
14,212

5.66
7.63
2.65
4.58
$2.22

5.66
7.63
2.65
4.62
$2.22

5.27
4.87
2.46
4.15
$1.88

990
7.91%

1047
7.91%

783
5.60%

RATIOS
AR turn
INV turn
AP turn
FLEV
Div/sh
CAPEX
CAPEX/Sales

9-27

3,403
2,058
148 (NOTE 8)
606
6,215

Chapter 09 - Prospective Analysis

Case 9-1 continued


Statement of Cash Flows

20x7 Estim.

Net income

$ 582

Depreciation

766

Accounts receivable

127

Inventories

62

Accounts payable

(178)

Net cash flow from operations

1,359

CAPEX
Net cash flow from investing activities

(990)
(990)

Long term debt


Dividends
Net cash flow from financing activities

(156)
(643)
(799)
_____
(431)
448
$ 17

Net change in cash


Beginning cash
Ending cash

9-28

Chapter 09 - Prospective Analysis

Case 9-2 (120 minutes)


Miller Company
Cash Forecast
For Years Ended December 31, Years 2 through 4
Year 2
Year 3
Cash balance at beginning of period .................. $
0 $1,929,000
Cash received from stockholders .......................
100,000
0
Proceeds of loan (see [a]) .................................... 1,700,000
100,000
Cash receipts less cash payments (see [b]).......
129,000
125,500
Payments for construction...................................
0 (1,700,000)
Payments on loan (see [a])...................................
0 (200,000)
Cash balance at end of period ............................. $1,929,000 $ 254,500

Year 4
$254,500
0
0
146,500
(100,000)
(200,000)
$101,000

Supporting Schedules for the Cash Forecast


[a] Schedule of interest and commitment fees
Amount of
Loan
Year 2:
To be borrowed 1/1 ..................................................................
To be borrowed 4/1 ..................................................................
Commitment fee due 4/1 ($1,000,000 x 1% x 1/4) ..................
To be borrowed 7/1 ..................................................................
Commitment fee due 7/1 ($500,000 x 1% x 1/4) .....................
To be borrowed 12/31 ..............................................................
Commitment fee due 12/31 ($200,000 x 1% x 1/2) .................
Interest due on loan:
On $800,000 @ 5%..............................................................
On $500,000 @ 5% x 3/4.....................................................
On $300,000 @ 5% x 1/2.....................................................
Total at 12/31/Year 2.................................................................
Year 3:
To be borrowed 4/1 ..................................................................
Commitment fee due 4/1 ($100,000 x 1% x 1/4) .....................
Repayment of loan:
Due 6/30 ..............................................................................
Due 12/31 ............................................................................
Interest due on loan:
On $1,700,000 @ 5% x 1/4..................................................
On $1,800,000 @ 5% x 1/4..................................................
On $1,700,000 @ 5% x 1/2..................................................
Total at 12/31/Year 3.................................................................
Year 4:
Repayment of loan:
Due 6/30 ..............................................................................
Due 12/31 ............................................................................
Interest due on loan:
On $1,600,000 @ 5% x 1/2..................................................
On $1,500,000 @ 5% x 1/2..................................................
Total at 12/31/Year 4.................................................................

9-29

$ 800,000
500,000
300,000
100,000

$1,700,000
100,000

Interest
or Fee

$ 2,500
1,250
1,000
40,000
18,750
7,500
$71,000
250

(100,000)
(100,000)

$1,600,000

21,250
22,500
42,500
$86,500

(100,000)
(100,000)

$1,400,000

40,000
37,500
$77,500

Chapter 09 - Prospective Analysis

Case 9-2 continued


[b] Schedule of Operating Results
Year 2

Year 3

Year 4

Operating profit (at $.04 per ton handled) .................

$200,000

$212,000

$224,000

Interest and commitment fees (above) ......................

71,000

86,500

77,500

Cash derived from operations ....................................

129,000

125,500

146,500

Depreciation (at $.03 per ton handled) .......................

150,000

159,000

168,000

Operating loss ..............................................................

$ 21,000

33,500

21,500

Operating loss from prior year(s) ...............................

21,000

54,500

Accumulated operating loss .......................................

$ 54,500

$ 76,000

Results of operations

Interpretation and Evaluation


As revealed in note [b], reporting on the "results of operations," Miller Company
is expected to record operating losses for each of the next three years under
analysis. Nevertheless, the analysis also reveals that Miller is expected to
generate sufficient cash flow to cover the various cash commitments.

9-30

Chapter 09 - Prospective Analysis

Case 9-3 (100 minutes)


Royal Company
Cash Forecast
For Years Ending March 31, Years 6 and 7
Year 6

Beginning balance of cash ......................................

Year 7

75,000

Cash receipt from customers (see Schedule A) ....


Cash disbursements
Direct materials (see Schedule B) .........................
Direct labor ..............................................................
Variable overhead ...................................................
Fixed costs .............................................................
Total cash disbursements .....................................
Operating cash receipts less disbursements ........

825,000

1,065,000

220,000
300,000
100,000
130,000
750,000
75,000

245,000
360,000
120,000
130,000
855,000
210,000

Cash from sale of receivables and inventories .....


Total cash available ..................................................

90,000
$165,000

0
$ 285,000

Payments to general creditors ................................


Ending balance of cash ............................................

90,000
$ 75,000 1

270,000
$ 15,000

1
2

This amount could have been used to pay general creditors or carried forward to the beginning
of the next year.
Computed as: ($600,000 x 60%) - ($50,000 + $40,000).

Schedule A
Cash Receipts from Customers
Year 6
Sales .......................................................................................... $900,000
Beginning accounts receivable ..............................................
0
Total.........................................................................................
900,000
Less: Ending accounts receivable .........................................
75,000
Cash receipts from customers ............................................... $825,000

Year 7
$1,080,000
75,000
1,155,000
90,000
$1,065,000

Schedule B
Cash Disbursements for Direct Materials
Year 6
Direct materials required for production ...................
$200,000
Required ending inventory..........................................
40,000
Total.............................................................................
240,000
Less: Beginning inventory ..........................................
0
Purchases ..................................................................
240,000
Beginning accounts payable ......................................
0
Total.............................................................................
240,000
Less: Ending accounts payable .................................
20,000
Disbursements for direct materials ............................
$220,000
3
4

Computed as: 12,000 units x 2/12 = 2,000; 2,000 x $20 per unit = $40,000.
Computed as: 15,000 units x 2/12 = 2,500; 2,500 x $20 per unit = $50,000.

9-31

Year 7
$240,000
50,000
290,000
40,000
250,000
20,000
270,000
25,000
$245,000

Chapter 09 - Prospective Analysis

Case 9-4 (115 minutes)


a.
(1)
Estimated Total Cash Receipts
Sep.
Oct.
Total sales ............................................. $40,000
$48,000
12,000
Credit sales (25%) .................................
10,000
$45,000
Cash sales ................................ $30,000 36,000
Receipts of past month's credit sales
10,000
Total cash receipts ...............................
$46,000

Nov.
$60,000
15,000
$60,000
12,000
$57,000

Dec.
$80,000
20,000
15,000
$75,000

(2)
Estimated Cash Disbursements for Purchases
Oct.
Nov.
Dec.
Total Sales ........................................
$48,000 $60,000
$80,000
Purchases (70% next mo. sales) ....
Less: 2% purchase discount ..........
Cash disbursements .......................

$42,000
840
$41,160

$56,000
1,120
$54,880

Total

$25,200 $123,200
504
2,464
$24,696 $120,736

(3)
Estimated Cash Disbursements for Operating Expenses
Oct.
Nov.
Dec.
Sales ................................................. $48,000
$60,000
$80,000
Salaries and Wages (15%) .............. $ 7,200
Rent (5%) ..........................................
2,400
Other Expenses (4%) .......................
1,920
Cash disbursements ....................... $11,520

$ 9,000
3,000
2,400
$14,400

Total

$12,000
4,000
3,200
$19,200

$28,200
9,400
7,520
$45,120

Estimated Total Cash Disbursements


Oct.
Nov.
Dec.
Purchases [part (2)] ......................... $41,160
$54,880
$24,696
Operating expenses [part (3)] .........
11,520
14,400
19,200
400
Plant and equipment (given) ...........
600
$69,680
$43,896
Total cash disbursements .............. $53,280

Total
$120,736
45,120
1,000
$166,856

(4)

(5)
Estimated Net Cash Receipts and Disbursements
Oct.
Nov.
Dec.
Total cash receipts .......................... $46,000
$57,000
$75,000
69,680
43,896
Total cash disbursements ..............
53,280
Net cash increase ............................
$31,104
Net cash decrease ........................... $ 7,280
$12,680

9-32

Total
$178,000
166,856
$ 11,144

Chapter 09 - Prospective Analysis

Case 9-4 continued


(6)
Estimated Financing Required
Oct.
Nov.

Beginning cash balance .................. $12,000

Dec.

$ 8,720

Net cash increase ............................


Net cash decrease ...........................

7,280

Cash position before financing ...... $ 4,720


Financing required ..........................

4,000

Total

$ 8,040

$12,000

31,104

11,144

$39,144

$23,144

12,680
$(3,960)
12,000

16,000

Interest expense ............................

(180)

(180)

Financing retired ..............................

(16,000)

(16,000)

$22,964

$22,964

Ending cash balance ....................... $ 8,720


1

$ 8,040

Computed as: ($4,000 x .06 x 3/12) + ($12,000 x .06 x 2/12).

b. (1)
Union Corporation
Forecasted Income Statement
For the Quarter Ended December 31, Year 6

Sales [see (1) in part a] .......................................................

$188,000

Deduct
Cost of goods sold (70% of sales) ...............................

$131,600

Less: Purchase discounts taken [see (2) in part a] ....

2,464

Gross profit .........................................................................

129,136
58,864

Selling and administrative expenses


Salaries and wages [see (3) in part a] .........................

28,200

Rent [see (3) in part a] ...................................................

9,400

Other expenses [see (3) in part a] ................................

7,520

Depreciation ($750 x 3 months) ...................................

2,250

Total selling and administrative expenses .......................

47,370

Operating income ...............................................................

11,494

Interest expense .................................................................

180

Net income

.......................................................................

9-33

$ 11,314

Chapter 09 - Prospective Analysis

Case 9-4 continued


(2)
Union Corporation
Forecasted Balance Sheet
As of December 31, Year 6

ASSETS
Current Assets
Cash [see (6) in part a] ..................................................

$ 22,964

Accounts receivable (25% of Dec. sales) ....................

20,000

Inventory [($30,000 + 70% of $36,000) x 98%].............

54,096

Total current assets ............................................................

$ 97,060

Plant and equipment ..........................................................

101,000

Less: Accumulated depreciation ......................................

2,250

Total assets .........................................................................

98,750
$195,810

LIABILITIES AND EQUITY


Liabilities .............................................................................

Stockholders' equity ...........................................................

195,810

Total liabilities and equity ..................................................

$195,810

9-34